Today is World Water Day (March 22). Comparing the longer-term drivers today versus a decade ago when the early water funds were first launched, we believe that the global water investment theme is, in fact, even more relevant than it was then. Additionally, after the macro challenges markets faced in 2011, stock valuations across the water sector were reset to some of the most attractive levels yet. But with water supply essentially fixed and demand growing to support population growth, changing diets, industrialisation, and continued migration to cities and drier regions, localised water supply-demand imbalances are getting worse around the globe. As we cross the seven billion global population mark, these trends are compounding. Further, climate change models predict dry regions getting drier and wet regions getting wetter, with more severe weather events. Countries and regions still have a long way to go to align sustainable supply with demand through a mixture of solutions, all of which are investable: long distance transfer, desalination, water re-use, and/or conservation. The massive under spending on water infrastructure rehabilitation and replacement simply means more pent-up demand for water equipment and services going forward. The current replacement rate of pipes of 0.37% per year implies a 250-300 year replacement cycle, far in excess of 75-100 year life of pipes. Common sense dictates that the pipes will eventually fail and need to be fixed. The truth is that this investment driver has yet to play out en masse and may not for a while. But when itdoes, it will likely be so materially overwhelming that it may change the face of public-private finance for water infrastructure – another investment driver that has yet to fully play out. As developed market spending on water infrastructure slows or declines, it is rapidly being offset and surpassed by emerging markets. Emerging markets used to be barely relevant from an investing point of view – total market spend was too low and the stocks generally too obscure or illiquid to invest. This is no longer the case. In the first five years of the millennium, the combined spending on water infrastructure (including irrigation) by China and India was only one-third of the spending in the US. The projected spend in the current 5-Year plans (two 5-Year plans later) for the two countries has grown nearly 10- fold and will be more than twice the spending in the US. Over the last decade, the number of investable and reputable companies in these high growth geographies has also grown, as has the emerging market exposure of global industrials based in the developed world. Today, emerging markets represent a sizable and attractive exposure in water portfolios. Environmental regulations can drive spending on advanced treatment technologies and testing equipment. While this driver was modestly beneficial over the last decade to the investment theme, the outlook is significantly better. In fact, regulations, among other drivers, are poised to drive ballast water treatment and shale gas/oil related water cycle management, which are the two most interesting – that is, fast
growing and large – water markets to emerge since reverse osmosis desalination a decade ago. The imminent approval of the International Maritime Organisation (IMO) ballast water treatment regulations means the market, according to leading UV treatment provider Danaher, will grow from $200 million today to $5 billion per year in 2017. Similarly, hydraulic fracking in the US and identification of similar shale plays around the globe, estimated at seven times the US opportunity, leads to a very large, rapidly growing market for water supply, test and measurement equipment, water chemicals, water treatment equipment, storage solutions, pumps, transportation and disposal assets, and engineering and consulting services. In other words, this end market uniquely touches a lot of the solution providers that are working to solve the related challenges. As regulators get their arms around the environmental issues, water cycle management in the energy patch will become a very sizeable investable theme – an opportunity that hardly existed a decade ago for investors.In the early years of water funds, outperformance was facilitated by the tailwind of acquisitions. Several water utilities were being bought, and big global industrial players were aggressively buying their way into water to capitalize on the positive trends. While the high acquisition valuations are gone, the theme is still very much alive. But this time around, investors are benefitting from owning both the targets and the buyers, who are able to generate earnings accretion and build a more sustainable, differentiated strategic position. The buyers are therefore becoming better companies in which to invest. While recent performance has been strong, valuation of water stocks today remain compelling. Investors who have been intrigued by the water theme but have yet to invest are now presented with an outstanding opportunity to access these long- term drivers at very attractive valuations in an environment where we expect support from near-term tailwinds.
Matthew Sheldon and Catherine Ryan are Portfolio Managers for Kleinwort Benson Investors’ Water Strategy